Inflation & The Cost of Living

Inflation: Definition & Measure

• Inflation is defined as a continuous rise in the
general price level
• Inflation is measured as the percentage change in
the price level
Pt  Pt 1
100 or ln( Pt )  ln( Pt 1 ) 100
Pt 1
Pt is the general price level at time t
• Further, it is calculated as
– Year-on-year (y-o-y) basis or
– Average of year/months/week/ Example
 Price Indices
• The most common price indices are
– Consumer Price Index (CPI)
– GDP Deflator
– Wholesale Price Index (WPI)

• Objective of CPI
• To measure changes in the cost of living and to act as an
indicator of how much income should rise in order to
maintain a constant standard of living.
 Computation of General Price Index,
CPI
• Fix the commodity basket on the basis of
importance assigned to various goods and
services by typical consumers for a reference
period
• Find the prices for each of the goods and services
included in the basket for several periods
including the reference period
• Calculate the basket’s cost for all the periods
holding quantity constant
• Calculate CPI as
 Problems with CPI Measure
• Substitution bias

– Change in relative prices

– Introduction of new goods

• Unmeasured quality changes

 GDP Deflator vs. CPI
• Domestically produced goods vs. goods
consumed by the consumers
– Eg. Aircrafts, factory machineries & equipments
– Imported goods and services consumed by the
consumers
• Fixed basket vs. goods produced in the current
year
• CPI is a better measure of cost of living
compared to GDP deflator
 Effects of Inflation

• Reduces real value of money or purchasing

power
– Real value of ₹1 = ₹1/price level

• Causes redistribution of income from savers-

investors to debtors
– Anticipated (expected) vs. unanticipated
(unexpected) inflation
 Types of Inflation
• By source
– Demand pull
– Cost push
• Profit push
• Wage push

• By intensity
– Low inflation
– Galloping or very high inflation
– Hyperinflation

• Deflation
 20
30
40
50
60
70

10

-10
0
South Sudan
Sierra Leone
Haiti
Ghana
Ethiopia
Kenya
Moldova
Mexico
Algeria
Uganda
Guatemala
Pakistan
Bhutan
Russian Federation
Brazil
Jordan
Kyrgyz Republic
Seychelles
Maldives
Niger
Chile
Belgium

Source: CPI (2010) collected from World Bank

Inflation 2017

Albania
Korea, Rep.
Sweden
Luxembourg
Canada
Bahrain
Guinea-Bissau
Slovak Republic
Belize
San Marino
Zimbabwe
Global Inflation Data; India ranks 60th among 159 Countries

Cabo Verde
Cote d'Ivoire
Singapore
Cyprus
Burkina Faso
Iraq
Saudi Arabia
 Indian Price Indices
Measures of general price level &inflation
• Wholesale Price Index (WPI)
• Consumer Price Index (CPI)
– CPI for Industrial Workers (CPI-IW)
– CPI – IW Food
– CPI for Agricultural Labourers (CPI-AL)
– CPI for Rural Labourers (CPI-RL) – discontinued
– CPI for Urban Non-manual Employees (CPI – UNME) -
discontinued
– New CPI Combined or CPI New Series (CPI-NS)
• New CPI Urban
• New CPI Rural
• GDP Deflator
• Private Final Consumption Expenditure (PFCE) Deflator
 Certain Characteristics

• CPI-IW has a broader coverage than the other three CPIs

and was used as a cost of living index for the organized
sector prior to the introduction of CPI-NS.
• GDP deflator though a more comprehensive measure of
price level, it is available only on a quarterly basis with a
lag of 2 months since 1996.
• The main problem with WPI is that it does not include
service sector which constitute around 58 percent of Indian
GDP.
 Divergence between WPI & CPI
• Exclusion of Services by WPI
• Weighting patterns vary between CPI and WPI. Food has a larger share in
CPI (46.20 in CPI-IW 2010 base) compared to only 24.31 in WPI. On the
other hand, the fuel group has much higher weight (14.91) in WPI
compared to CPI which is often less than 10 percent (9.49).
• Outdated base period: The base period of WPI has been changed to 2004-
05 in and the new series has been launched on Sep 14, 2010. The old
series had 1993-94 as the base year. The new series has been developed
based on the recommendations of the Working Group set up with Prof
Abhijit Sen, Member, Planning Commission as Chairman for revision of
WPI series. The new series has 676 commodities compared to 435 in the
1993-94 based WPI. The CPI-IW base has also been changed from 1982 to
2001 while for CPI-AL the base period is still 1986-87. The CPI-NS or
New CPI has 2012 as the base period and considers 200 weighted
products.
Calculation
Group Sub-Group Weights
New CPI Basket Description
code Code Rural Urban Combined
(1) (2) (3) (4) (7) (10)
1.1.01 Cereals and products 12.35 6.59 9.67
1.1.02 Meat and fish 4.38 2.73 3.61
1.1.03 Egg 0.49 0.36 0.43
1.1.04 Milk and products 7.72 5.33 6.61
1.1.05 Oils and fats 4.21 2.81 3.56
1.1.06 Fruits 2.88 2.90 2.89
1.1.07 Vegetables 7.46 4.41 6.04
1.1.08 Pulses and products 2.95 1.73 2.38
1.1.09 Sugar and Confectionery 1.70 0.97 1.36
1.1.10 Spices 3.11 1.79 2.50
1.2.11 Non-alcoholic beverages 1.37 1.13 1.26
1.1.12 Prepared meals, snacks, sweets etc. 5.56 5.54 5.55
1 Food and beverages 54.18 36.29 45.86
2 Pan, tobacco and intoxicants 3.26 1.36 2.38
3.1.01 Clothing 6.32 4.72 5.58
3.1.02 Footwear 1.04 0.85 0.95
3 Clothing and footwear 7.36 5.57 6.53
4 Housing - 21.67 10.07
5 Fuel and light 7.94 5.58 6.84
6.1.01 Household goods and services 3.75 3.87 3.80
6.1.02 Health 6.83 4.81 5.89
6.1.03 Transport and communication 7.60 9.73 8.59
6.1.04 Recreation and amusement 1.37 2.04 1.68
6.1.05 Education 3.46 5.62 4.46
6.1.06 Personal care and effects 4.25 3.47 3.89
6 Miscellaneous 27.26 29.53 28.32
 Calculation: Laspeyres Formula
Price indices are calculated as

I
 (I W )
i i i

W i i

Where Ii are indices for individual commodity groups, Wi is the weight

attached to the ith group and Ii is calculated as
pit
i p wi 0
Ii  i0

i wi 0
Where wi0 is the share of expenditure on the ith commodity in
the base period